Asset Class Valuation Update

Our market valuation analyses are based on the assumption that markets are not perfectly efficient and always in equilibrium. This means that it is possible for the supply of future returns a market is expected to provide to be higher or lower than the returns investors logically demand. In the case of an equity market, we define the future supply of returns to be equal to the current dividend yield plus the rate at which dividends are expected to grow in the future. We define the return investors demand as the current yield on real return government bonds plus an equity market risk premium. As described in our May, 2005 issue, people can and do disagree about the "right" values for these variables. Recognizing this, we present four valuation scenarios for an equity market, based on different values for three key variables. First, we use both the current dividend yield and the dividend yield adjusted upward by .50% to reflect share repurchases. Second, we define future dividend growth to be equal to the long-term rate of total (multifactor) productivity growth, which is equal to either 1% or 2%. Third, we use two different values for the equity risk premium required by investors: 2.5% and 4.0%. Different combinations of these variables yield high and low scenarios for both the future returns the market is expected to supply, and the future returns investors will demand. We then use the dividend discount model to combine these scenarios, to produce four different views of whether an equity market is over, under, or fairly valued today.

The specific formula is (Current Dividend Yield x 100) x (1+ Forecast Productivity Growth) divided by (Current Yield on Real Return Bonds + Equity Risk Premium - Forecast Productivity Growth). Our valuation estimates are shown in the following tables, where a value greater than 100% implies overvaluation, and less than 100% implies undervaluation.

Equity Market Valuation Analysis at 30 April 2008

Our government bond market valuation update is based on the same supply and demand methodology we use for our equity market valuation update. In this case, the supply of future fixed income returns is equal to the current nominal yield on ten-year government bonds. The demand for future returns is equal to the current real bond yield plus the historical average inflation premium (the difference between nominal and real bond yields) between 1989 and 2003. To estimate of the degree of over or undervaluation for a bond market, we use the rate of return supplied and the rate of return demanded to calculate the present values of a ten year zero coupon government bond, and then compare them. If the rate supplied is higher than the rate demanded, the market will appear to be undervalued. This information is contained in the following table.

Bond Market Analysis as of 30 April 2008

It is important to note some important limitations of this analysis. First, it uses the current yield on real return government bonds (or, in the cases of Switzerland and India, the implied real yield if those bonds existed). Over the past forty years or so, this has averaged around 3.00%. Were we to use this rate, the required rate of return would generally increase. Theoretically, the "natural" or equilibrium real rate of interest is a function of three variables: (1) the expected rate of multifactor productivity growth (as it increases, so to should the demand for investment, which will tend to raise the real rate) (2) risk aversion (as investors become more risk averse they save more, which should reduce the real rate of interest, all else being equal); and (3) the time discount rate, or the rate at which investors are willing to trade off consumption today against consumption in the future. A higher discount rate reflects a greater desire to consume today rather than waiting (as consumption today becomes relatively more important, savings decline, which should cause the real rate to increase). These variables are not unrelated; a negative correlation (of about .3) has been found between risk aversion and the time discount rate. This means that as people become more risk averse, they also tend to be more concerned about the future (i.e., as risk aversion rises, the time discount rate falls).

All three of these variables can only be estimated with uncertainty. For example, a time discount rate of 2.0% and risk aversion factor of 4 are considered to be average, but studies show that there is wide variation within the population and across the studies themselves. The analysis in the following table starts with current real return bond yields and the OECD's estimates of multifactor productivity growth between 1995 and 2002 (with France and Germany proxying for the Eurozone). We then try to back out estimates for risk aversion and the time discount rate that would bring theoretical rates into line with those that have been observed in the market. The real rate formula is [Time Discount Rate + ((1/Risk Aversion Factor) x MFP Growth)].

Real Interest Rate Analysis at 30 April 2008

Our bond market analysis also uses historical inflation as an estimate of expected future inflation. This may not produce an accurate valuation estimate, if the historical average level of inflation is not a good predictor of average future inflation levels. For example, if expected future inflation is lower than historical inflation, required returns will be lower. Also, if one were to assume a very different scenario, involving a prolonged recession, accompanied by deflation, then one could argue that government bond markets are actually undervalued today.

Let us now turn to the subject of the valuation of non-government bonds. Some have suggested that it is useful to decompose the bond yield spread into two parts. The first is the difference between the yield on AAA rated bonds and the yield on the ten year Treasury bond. Because default risk on AAA rated companies is very low, this spread may primarily reflect prevailing liquidity and jump (regime shift) risk conditions. The second is the difference between BBB and AAA rated bonds, which may tell us more about the level of compensation required by investors for bearing default risk. For example, between August and October, 1998 (around the time of the Russian debt default and Long Term Capital Management crises), the AAA-Treasury spread jumped from 1.18% to 1.84%, while the BBB-AAA spread increased by much less, from .62% to .81%. This could be read as an indication of investor's higher concern with respect to the systematic risk implications of these crises (i.e., their potential to shift the financial markets into the low return, high volatility regime), and lesser concern with respect to their impact on the overall pricing of credit risk.

The following table shows the average level of these spreads between January, 1970 and December, 2005 (based on monthly Federal Reserve data), along with their standard deviations and 67% (average plus or minus one standard deviation) and 95% (average plus or minus two standard deviations) confidence range.

At 30 April 2008, the AAA minus 10 year Treasury spread was 1.76%. This is was a significant decline from the previous month, which indicates some moderation in fixed income market jitters. However, it is still significantly above the long-term average compensation for bearing liquidity and jump risk (assuming our model is correct), and reflects a clear market reaction to the problems that have roiled the fixed income markets since August and have yet to fully abate.

At the end of the month, the BBB minus AAA spread was 1.36%. This is not significantly above the long-term average compensation for bearing credit risk. However, it still seems low given that conditions in the real economy continue to deteriorate. We still believe that it is more likely that credit risk is underpriced rather than overpriced today, and that corporate bonds remain overvalued rather than undervalued.

For an investor contemplating the purchase of foreign bonds or equities, the expected future annual percentage change in the exchange rate is also important. Study after study has shown that there is no reliable way to forecast this, particularly in the short term. At best, you can make an estimate that is justified in theory, knowing that in practice it will not turn out to be accurate. That is what we have chosen to do here. Specifically, we have taken the difference between the yields on ten-year government bonds as our estimate of the likely future annual change in exchange rates between two regions. According to theory, the currency with the relatively higher interest rates should depreciate versus the currency with the lower interest rates. Of course, in the short term this often doesn't happen, which is the premise of the popular hedge fund "carry trade" strategy of borrowing in low interest rate currencies, investing in high interest rate currencies, and, essentially, betting that the change in exchange rates over the holding period for the trade won't eliminate the potential profit. Because (as noted in our June 2007 issue) there are some important players in the foreign exchange markets who are not profit maximizers, carry trades are often profitable, at least over short time horizons. Our expected medium to long-term changes in exchange rates are summarized in the following table:

Annual Exchange Rate Changes Implied by Bond Market Yields on 30 April 2008

	To AUD	To CAD	To EUR	To JPY	To GBP	To USD	To CHF	To INR
From
AUD	0.00%	-2.67%	-2.16%	-4.65%	-1.61%	-2.53%	-3.15%	1.76%
CAD	2.67%	0.00%	0.51%	-1.98%	1.06%	0.14%	-0.48%	4.43%
EUR	2.16%	-0.51%	0.00%	-2.49%	0.55%	-0.37%	-0.99%	3.92%
JPY	4.65%	1.98%	2.49%	0.00%	3.04%	2.12%	1.50%	6.41%
GBP	1.61%	-1.06%	-0.55%	-3.04%	0.00%	-0.92%	-1.54%	3.37%
USD	2.53%	-0.14%	0.37%	-2.12%	0.92%	0.00%	-0.62%	4.29%
CHF	3.15%	0.48%	0.99%	-1.50%	1.54%	0.62%	0.00%	4.91%
INR	-1.76%	-4.43%	-3.92%	-6.41%	-3.37%	-4.29%	-4.91%	0.00%

Our approach to valuing commercial property securities as an asset class is hindered by a lack of historical data about rates of dividend growth. To overcome this limitation, we have assumed that markets are fairly valued today (i.e., the expect supply of returns equals the expected returns demanded by investors), and "backed out" the implied growth rates to see if they are reasonable in light of other evidence about the state of the economy (see below). This analysis assumes that investors require a 2.5% risk premium above the yield on real return bonds to compensate them for the risk of securitized commercial property as an asset class. The following table shows the results of this analysis:

Commercial Property Securities Analysis as of 30 April 2008

If you think the implied real growth estimates in the last column are too high relative to your expectation for the future real growth in average rents, this implies commercial property securities are overvalued today. On the other hand, if you think the implied growth rate is too low, that implies undervaluation. Since we expect a significant slowdown in the global economy over the next few years, we are inclined to view most of these implied real growth assumptions as still too optimistic (though less so than before), and therefore to believe that the balance of business cycle and valuation evidence suggests that commercial property securities in many markets are likely overvalued today.

Our approach to assessing the current valuation of timber is based on two publicly traded timber REITS: Plum Creek (PCL) and Rayonier (RYN). As in the case of equities, we compare the return these are expected to supply (defined as their current dividend yield plus the expected growth rate of those dividends) to the equilibrium return investors should rationally demand for holding timber assets (defined as the current yield on real return bonds plus an appropriate risk premium for this asset class). As is the case with equities, two of these variables are published: the dividend yields on the timber REITS and the yield on real return bonds. The other two variables have to be estimated. A number of factors contribute to the expected future growth rate of timber REIT dividends. These are listed in the following table, along with the assumptions we make about their future values:

Average Dividend Yield	4.40%
Plus Long Term Annual Biological Growth	6.00%
Less Percent Harvested Each Year	(5.00%)
Plus Average Annual Ingrowth Value Increase	3.00%
Plus Long Term Real Annual Price Change	0.00%
Plus Other Sources of Annual Value Increase (e.g., Carbon Credits)	0.00%
Equals Average Annual Real Return Supplied	8.40%
Real Bond Yield	1.59%
Plus Risk Premium for Timber	4.00%
Equals Average Annual Real Return Demanded	5.59%
Ratio of Returns Demanded/Returns Supplied Equals Valuation Ratio (less than 100% implies undervaluation)	67.0%

Our approach to assessing the current value of equity market volatility (as measured by the VIX index, which tracks the level of S&P 500 Index volatility implied by the current pricing of put and call options on this index) is similar to our approach to commodities. Between January 2, 1990 and December 30, 2005, the average value of the VIX Index was 19.45, with a standard deviation of 6.40. The one standard deviation (67% confidence interval) range was 13.05 to 28.85, and the two standard deviations (95% confidence) range was from 6.65 to 32.25. On 30 April 2008, the VIX closed at 20.79, slightly above its long term average value. However, we believe this level is too low in light of rising uncertainty in the world economy and continuing turmoil in financial markets. Hence, we conclude that equity volatility is likely still undervalued today.

Sector and Style Rotation Watch

The following table shows a number of classic style and sector rotation strategies that attempt to generate above index returns by correctly forecasting turning points in the economy. This table assumes that active investors are trying to earn high returns by investing today in the styles and sectors that will perform best in the next stage of the economic cycle. The logic behind this is as follows: Theoretically, the fair price of an asset (also known as its fundamental value) is equal to the present value of the future cash flows it is expected to produce, discounted at a rate that reflects their relative riskiness.

Current economic conditions affect the current cash flow an asset produces. Future economic conditions affect future cash flows and discount rates. Because they are more numerous, expected future cash flows have a much bigger impact on the fundamental value of an asset than do current cash flows. Hence, if an investor is attempting to earn a positive return by purchasing today an asset whose value (and price) will increase in the future, he or she needs to accurately forecast the future value of that asset. To do this, he or she needs to forecast future economic conditions, and their impact on future cash flows and the future discount rate. Moreover, an investor also needs to do this before the majority of other investors reach the same conclusion about the asset's fair value, and through their buying and selling cause its price to adjust to that level (and eliminate the potential excess return).

We publish this table to make an important point: there is nothing unique about the various rotation strategies we describe, which are widely known by many investors. Rather, whatever active management returns (also known as "alpha") they are able to generate is directly related to how accurately (and consistently) one can forecast the turning points in the economic cycle. Regularly getting this right is beyond the skills of most investors. In other words, most of us are better off just getting our asset allocations right, and implementing them via index funds rather than trying to earn extra returns by accurately forecasting the ups and downs of different sub-segments of the U.S. equity and debt markets. That being said, the highest rolling three month returns in the table give a rough indication of how investors expect the economy and interest rates to perform in the near future. The highest returns in a given row indicate that most investors are anticipating the economic and interest rate conditions noted at the top of the next column (e.g., if long maturity bonds have the highest year to date returns, a plurality of bond investor opinion expects rates to fall in the near future). Comparing returns across strategies provides a rough indication of the extent of agreement (or disagreement) investors about the most likely upcoming changes in the state of the economy.

When the rolling returns on different strategies indicate different conclusions about the most likely direction in which the economy is headed, we place the greatest weight on bond market indicators. Why? We start from a basic difference in the psychology of equity and bond investors. The different risk/return profiles for these two investments produce a different balance of optimism and pessimism. For equities, the downside is limited (in the case of bankruptcy) to the original value of the investment, while the upside is unlimited. This tends to produce an optimistic view of the world. For bonds, the upside is limited to the contracted rate of interest and getting your original investment back (assuming the bonds are held to maturity). In contrast, the downside is significantly greater - complete loss of principal. This tends to produce a more pessimistic (some might say realistic) view of the world. As we have written many times, investors seeking to achieve a funding goal over a multi-year time horizon, avoiding big downside losses is arguably more important than reaching for the last few basis points of return. Bond market investors' perspective tends to be more consistent with this view than equity investors' natural optimism. Hence, when our rolling rotation returns table provides conflicting information, we tend to put the most weight on bond investors' implied expectations for what lies ahead.

Three Month Rolling Nominal Returns on Classic Rotation Strategies in the U.S. Markets

Rolling 3 months returns through: 30 April 2008

The following table sums up our subjective view of possible asset class under and overvaluations at the end of April 2008. The distinction between possible, likely and probable reflects a rising degree of confidence in our conclusion.

Probably Overvalued	Commodities, Corporate Bonds/Credit Risk, Equity Markets in Canada, Japan, the U.S. and India
Likely Overvalued	Commercial Property except Australia
Possibly Overvalued	India, U.S., Canada and Eurozone Govt Bonds
Possibly Undervalued	Australian Dollar and UK Pound Government Bonds; UK Equity; Australia Commercial Property; Non-U.S. Dollar Bonds
Likely Undervalued	Australian Dollar Real Return Bonds; U.K. Equity; Equity Volatility; Timber (in long run, if not short run given downward pricing pressure)
Probably Undervalued

| 2007-2008 Benchmark Portfolios - All Currencies | This Month's Issue: Key Points | Product and Strategy Notes: Interesting New Research; New ETF Products - RWO, GRI, FFR, CYB, ICN, UHN and DYY/DEE; Canadian Asset Allocation ETFs; Vanguard & Russell Retirement Products; and New Research Investing After Retirement | May 2008 Economic Update | This Month's Letters to the Editor: Nominal vs Real Calculations, Canadian Oil Trusts - Claymore's ENY and Omega Function in Optimization | Global Asset Class Returns | Asset Class Valuation Update |